Is Italy a threat to investments?
Italian policymakers have voiced desires to deliver economically destabilising policies while also suggesting that they might be inclined to leave the euro currency area. If this were to happen, not only would it undermine the foundations of the European project, it would also be devastating for the Italian banking sector and all the pensions and savings that it holds. That would make the populist government very unpopular, and that’s why it’s probably not going to happen. Well not yet.
Parallels with Greece
The Italian economy is one of the ten largest in the world, and ranks fourth in the European Union (EU) behind Germany, France and the UK. But Italy is increasingly being mentioned in similar terms to the way in which Greece was eight years ago. Back then, Greece was suffering under a burden of debt that its economy could not sustain. With an annual gross domestic product (GDP) of around €175bn, (approximately £160bn) the more than €260bn of debt (150% of GDP) required interest payments that the Greeks could not maintain. As a result, after much wrangling, the Greek debt was restructured with loans from the International Monetary Fund, the World Bank and the European Union.
The Italian economy is nine times bigger with an annual GDP of around €1,600bn, while its government debt has stayed steadily around 130% of GDP for the past four years, even as the GDP declined from around €2,100bn. That debt burden might sound substantial, but is a relatively manageable level for the Italian economy, even though it demands annual interest payments of around $90bn. That is relatively cheap thanks to the prevailing low interest rates within the eurozone.
As things stand with Italy in the eurozone and having registered moderate economic growth over the past 12 months, the public debt for Italy represents less of a domestic threat than that experienced by Greece back in 2010.
Too many banks
What is more concerning is the precarious situation of Italy’s banks. In the run-up to the financial crisis 10 years ago, Italian banks were among many that extended loans and mortgages to customers with, it turned out, insufficient ability to repay. As a result, Italian banks have been in severe trouble ever since.
European Central Bank Governor, Mario Draghi, pointed out in 2016 that there are too many banks in Europe(1). There are more than 600 banks in Italy; contrast that with the 350-odd in the UK if you include building societies. There aren’t enough deposits to sustain all of those Italian banks on an efficient and profitable basis, especially with the burden of bad debt that they are carrying.
Too much bad debt
The bad debt (i.e. loans extended to customers on which repayments have stopped or been missed) across Italian banks reached €370bn in June (2), the highest in absolute terms of any European country. By way of comparison, the proportion of all loans extended that were registered as “non-performing” at the end of 2017 in the UK was a very acceptable 0.8%, while that of Italy was a painful 13.5%(3).
Banks expect a small amount of bad debt, that’s part-and-parcel of the banking business. But that has to be kept under control, otherwise the bank could be at risk of being unable to meet its own obligations and that’s when things can spiral out of control.
How banks work
To understand this better, we need to consider the basic principle of how a bank works. Let’s assume you place £100 cash in a deposit with Big Bank plc. Big Bank will pay you a small amount of interest on that deposit, but you can withdraw that entire £100 at short notice. The chances that all depositors will want all their money at the same time is remote and tends only to happen when there is a panic about the given bank’s ability to meets its obligations, and that can lead to a “bank run”. There has only been one of these in past 150 years in the UK, namely that of Northern Rock in 2007 when depositors feared that that bank would go bust and take their savings with it.
With bank runs so rare, Big Bank can use the £100 that you’ve deposited and lend around 90% of it to other customers, charging them a higher rate of interest than Big Bank is paying you. So you’ve deposited £100 and might earn, say, 0.5% i.e. 50p a year. The bank has lent £90 to a customer and might charge 2.5% i.e. £2.25 a year. The more the bank lends out, the more profit it might be able to make, but the higher the risk it takes of being unable to meet the needs of customers who want to withdraw their savings.
That’s why banks are required to keep minimum amounts of cash and other easy-to-sell or “liquid” assets on hand so that they can meet their short-term liabilities. In the EU, this minimum capital adequacy ratio, as it is called, is 10.5%. So if a bank has lent a total of £1,000 to customers, it must have at least 10.5%, i.e. £105 in this example, in liquid assets.
Low-risk rated bonds are used because the bond issuer (effectively the borrower) has a high probability of repaying the capital and of making the annual interest payments. That also tends to make those bonds relatively easy to sell should a bank need the cash at short notice.
More bad debt requires more cash and bonds to be held
Without going into too much technical detail, the more bad debt a bank has, the more cash and bonds it must keep to hand to offset that bad debt and maintain a capital adequacy ratio at or above 10.5%. As we have seen, Italian banks have a lot of bad debt. In fact, the total amount being carried by Italian banks is estimated to be running at around €165bn, and that’s after €64bn-worth of bad debt was disposed of in 2017 (4).
1. Mario Draghi speaking at the ECB during the first annual conference of the European Systemic Risk Board in September, 2016.
2. Source: “Italian banks face high-risk choice over domestic debt”, Reuters, 24 August 2018.
3. Source: CEICdata.com, accessed 5 September 2018 banks is estimated to be running at around €165bn, and that’s after €64bn-worth of bad debt was disposed of in 2017.
4. Source; The Italian NPL market, PwC, June 2018. “Disposals” can include bonds being written off during the respective bank’s accounting procedure and recorded as a loss, or the loans being sold at much less than their face value to another entity that feels it can get repayment totalling more than they paid for the loans.
British banks have maintained an overall capital adequacy ratio of just over 20% since the middle of 2016(5). This provides a nice buffer should their liabilities increase or the value of the bonds and other liquid assets decrease.
Italian banks do not have this luxury. According to The World Bank(6), Italian banks’ capital to assets ratio was around 6.6% in 2017, the most recent data available. This has limped up from 4.1% during the financial crisis, but still remains worryingly low. That’s what people are referring to when they talk about Italian banks being undercapitalised.
It gets worse.
Italian banks’ liquid assets include Italian government bonds. Since May of this year, investors have become increasingly wary of those bonds as the populist coalition government has talked about taking steps that could destabilise the Italian economy, its financial system and the government’s ability to maintain payments on outstanding bonds.
As a result, the demand for and price of those bonds have fallen. That’s bad news for banks because it reduces the value of some of their liquid assets, putting downward pressure on capital adequacy ratios and, more importantly, their ability to meet daily transaction requirements i.e. their ability to stay in business.
It should be no surprise, then, that there was a substantial sell-off of Italian bank shares. The FTSE Italian All Share Banks Index dropped by a whopping 30% between its mid-May high and its low-point for the year-to-date in late August.
Disciplining the government
Ironically, this acute vulnerability might provide precisely the discipline that the Italian policymakers need.
Promises of a universal minimum salary, a flat tax and reversal of pension reforms sent the demand for and prices of Italian government bonds into a tailspin. If it were to press ahead with an increase in spending and a reduction in tax revenues, it would have to borrow more to make up the difference. But in doing so, it will increase the cost of borrowing while also persuading people to lose faith in Italian banks.
As the risks associated with a given bond increase, its price tends to fall and the reward that investors demand for holding it, its yield, rises. In May, the benchmark Italian Government 10-year bond had a reasonable yield of around 1.8%. That jumped in June and has been trading between 2.5% and 3.2% since.
Not only does that undermine the solvency of the Italian banking sector, it also makes government and private borrowing in the country more expensive. To give you an idea, imagine if your mortgage payments jumped by a full percentage point in one month.
That’s the sobering reality that the Italian coalition government faces, and that’s why the initial budget put forward in early September was relatively moderate, although not without some internal political fall-out.
Italy needs the European Union
The Italian coalition government has also been talking about withdrawing from the euro currency, if not the entire EU. But there are good reasons why they have backtracked on these comments.
5. Source: Bank of England banking sector regulatory capital 2018 Q1, published 28 June.
6. Source: data.worldbank.org, sourced 6 September 2018.
In leaving the euro currency, outstanding Italian bonds would still be denominated in euros, while the Italian economy would revert to Italian lira. The relatively low value of the lira compared to the euro might provide some help to large exporters such as Fiat and Eni. But that would be scant consolation to bondholders who would rightly foresee even greater risk associated with Italian bonds, pushing Italian bond yields even higher and exacerbating the problems associated with Italian banks and corporate funding (i.e. expensive borrowing).
That Italy is able to borrow at relatively cheap interest rates at all is largely to do with the fact that it shares the same central bank as economic powerhouse, Germany. Leaving the EU would immediately entail a hike in interest rates for Italian public and private debt, as the country would be risk-assessed solely according to its own national economy i.e. without the helpful association of Germany.
And the Italian economy is starkly divided. The North and South of Italy were brought together into one united country in the 1860s. This was a bit like uniting Greece and Germany today. The North developed a market economy during the Middle Ages, helping to seed the economic development across the rest of northern and western Europe. The South of Italy, or Mezzogiorno, “remained under feudalism well into the early twentieth century” to quote BCA Research (7).
Travel around Milan or Turin in the northern parts of Italy and there are substantial businesses, commerce and relative economic buoyancy. Spend a day driving in Naples down south, and you have to navigate your way past piles of rubbish that still bedeck the roads long after the public services strike that occurred when the municipality couldn’t afford to pay its workers.
The EU issues development grants to the Mezzogiorno which take a huge burden off the Italian government. As a result, the net cost to Italy of being in the EU equates to around 0.2% of the country’s GDP, i.e. virtually nothing. With low interest rates to boot, Italy’s internal divide is largely eased by membership of the EU.
Italian brinkmanship might be justified
Despite all of these compelling reasons, Italian politicians are squaring up to the EU. They are threatening to leave or, at least, break budgetary regulations by increasing the budget deficit beyond the parameters required by the European Commission as part of Eurozone currency membership.
They might be right to do so.
Over the past decade, banks have remained undercapitalised; lending by banks has dried up either because they can’t afford to lend or because borrowers are paying down debt; the labour force is relatively unproductive; rigid and under-educated; and economic growth has been limited (8).
Despite its best efforts, the European Central Bank’s (ECB) monetary stimulus measures have had little effect on the Italian economic woes. A further step by the ECB aimed specifically at simulating.
Italian financial and economic expansion failed. In 2017, the ECB increased the proportion of Italian government bonds that it bought from investors with the intention that the influx of cash to mostly Italian investors would be put into Italian banks on deposit or into Italian investments. But so low was the level of trust in Italian banks that much of the money ended up in German banks. So a load of cash left Italy.
7. Source: Mediterranean Europe: Contagion risk or bear trap?, BCA Research, 13 June 2018.
8. Source: Mediterranean Europe: Contagion risk or bear trap?, BCA Research, 13 June 2018.
Fiscal stimulus needed
With monetary stimulus ineffective, fiscal stimulus (lower taxes, higher spending) should be considered. Yes this will increase the Italian government deficit (excess of spending over saving), but the current level of that deficit has fallen steadily from 5.2% in 2009 to 2.3% in 2017, the same as that of the UK and below those of France, Japan and the US(9).
If administered carefully, fiscal stimulus (funded by government borrowing) could stimulate a return of healthy private sector borrowing, spending and investment, all three of which are currently lacking in Italy.
That would equate to economic growth albeit at the expense of higher overall government debt. But if growth of the economy and government debt both increase at the same rate, then the proportion of debt to the size of the economy would reduce. For example, if GDP starts at 100 and government debt starts at 130 and both increase by 3, then government debt as a proportion of the economy would fall from 130% (130 ÷ 100) to 129% (133 ÷ 103).
Domestic political pressure
The final reason why the Italian government is probably posturing rather than really threatening to leave the currency or EU is because the Italians don’t want to: 60% of Italians want to remain in the EU while only 8% want to leave(10).
What’s more, the Italian economy posted a mild recovery over the past 12 months, if the country were to leave the EU or the euro currency, banks would suffer horrendously with many likely to go to the wall taking personal pensions and savings with them. That would set the blame squarely at the feet of the current coalition government which, while at times outspoken, seems less and less populist the closer you look.
An exit might be conceivable in a few years’ time if Italy were to suffer a sharp recession leading to job losses and social unrest. But the appetite does not seem to be there at the moment, and that’s how the EU should endeavour to keep it because Italy’s departure would shock the European financial system and undermine the very existence of the EU project.
Should investors be worried?
Probably not. There is too much at stake for both Brussels and more acutely, Rome. Italy’s economic and financial systems have not recovered to the same extent as other “peripheral” EU nations such as Ireland, Spain, Greece and Portugal. For example, labour costs in those countries have fallen by an average of 8.7% over the past decade while Italy’s remain relative unchanged; Ireland’s economy has leapt in size by 9.1% over the past year, while Spain and Portugal have registered 2.3% or more against Italy’s 1.2%(11). Even Greece beat that with 1.8%. So the Italian threats, while unnerving, shouldn’t pose a serious danger to investments in fellow EU countries.
An opportunity to buy?
Potentially. One could argue that when the assets in neighbouring countries fall as a result of Italian noise, the values of many of those neighbouring assets remains fundamentally sound. As such, falling prices could present a buying opportunity. It is worth noting, though, that this selection process requires a good degree of research and analysis and should not be entered into lightly.
The bottom line is, don’t panic. The Latin passion is on display, but it probably masks Teutonic pragmatism.
9. Source: Trading Economics banking sector regulatory capital, accessed 6 September 2018.
10. Source: Mediterranean Europe: Contagion risk or bear trap?, BCA Research, 13 June 2018.
11. Source: Trading Economics, accessed 6 September 2018.
Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at September 2018. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.
Important Legal Information
Lloyds Bank plc. Registered office: 25 Gresham Street, London EC2V 7HN. Registered in England and Wales, no. 2065. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority under number 119278.